Why do multinationals pay less profit tax? The inherent limitations of the arm’s length principle

Dominika Langenmayr08 September 2013

The realisation that multinational enterprises like Starbucks, Google and Amazon pay few taxes has sparked heated public debate, especially in the UK. This column questions whether widespread low tax payments are a sign of tax avoidance. Perhaps an alternative explanation is that multinational enterprises are able to shift profits abroad even if they fully comply with the law due to features inherent in the fundamentals of generic tax codes and the nature of large international firms.

Multinationals really matter in the global economy. Although this is hardly a new insight (Hymer 1960, Kindleberger 1969, Caves 1971), it is a feature that must be kept in mind when thinking about global taxation. Some multinationals have economic power similar to that of middle-income countries. General Electric for example, which is active in over 100 countries, earned revenues of $147 billion in 2012, more than the GDP of a medium-sized economy like Vietnam.

They often pay lower tax rates

Such enterprises are not only big, but also highly productive and profitable. They are consequently very attractive for governments, not only because they provide jobs, but their high profits also offer the opportunity to generate tax revenue.

However, there are widespread concerns that the profits of multinational firms are especially hard to tax, as – due to their internationality – they can avoid taxation in high-tax countries.

The coffee chain Starbucks, for example, had sales of £1.2 billion in the UK between 2009-2011 but, over the same period, paid no income tax despite describing itself as ‘profitable’ to its investors (see Reuters 2012).

Empirical studies such as Egger, Eggert and Winner (2010) confirm that multinational firms pay little tax relative to their profits.

Indeed, in European high-tax countries, subsidiaries of multinational corporations pay on average 32-57% less tax than similar domestically-owned firms (see Egger, Eggert and Winner 2010).

A new explanation: Multinationals are taxed at a ‘gorilla's arm's length’

It seems obvious to presume that multinational firms simply evade taxes by manipulating transfer prices or debt ratios. However, there is an additional possibility:

Low tax payments may arise due to tax law regulations rather than avoidance and evasion behaviour by the firms.

Indeed this possibility is cooked into the basic principles of international taxation – the ‘arm’s length’ principle. The arm’s length principle states that transactions between different subsidiaries of multinational corporations have to be treated – for tax purposes – as if they had taken place between independent parties. That is to say, as if the transaction had taken place on the market.

This presumes that there is no fundamental difference between multinationals and other firms.

Otherwise, the implied price for taxation is not correct. Recent findings in international economics, however, have shown that there are elemental differences between multinational and domestic firms:

First, multinational enterprises are much more productive than domestic firms.

In fact, it is the higher productivity that allows these firms to incur internationalisation costs and to become multinationals in the first place. They can thus produce the input at a lower cost than the price at which it sells on the market.

Second, market prices include a mark-up that arises from the bargaining between the firm and the independent supplier.

Because a subsidiary in a multinational has less bargaining power than an independent supplier, this mark-up also implies that market prices are higher than input prices within the firm.

If the multinational uses this market price to price intra-firm transactions for tax purposes (as the tax law requires it to do), it pays less tax in its home country and more in the location where it produces the input – but the latter is potentially a strategically chosen low-tax jurisdiction. As a result, the multinational company pays less tax than a comparable domestic firm.

This argument, explained in detail in Bauer and Langenmayr (2013), contributes to the explanation of the empirically observed lower effective tax rate of multinational firms. It does not exclude other strategies to minimise taxes, such as the manipulation of transfer prices, the strategic choice of the location of intellectual property, or the use of intra-firm loans. However, even if multinational enterprises did not act strategically to minimise their tax burden, the arm’s length principle would not guarantee that their tax payments are as high (relative to their profits) as those of purely domestic companies.